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Satyam not an isolated instance

C.P. Chandrasekhar

The Satyam episode is also the product of an institutional and regulatory environment that provides the space for one Satyam and, therefore, possibly for more such Satyams.

Attention in the Satyam case is now directed at saving the company and the jobs of its employees, and unravelling the acts of commission and omission that led up to the confession of fraud by chairman Ramalinga Raju. In the process, the systemic issues thrown up by assessments of specific failures — such as the failure of the auditors, the board or the regulators — may be ignored, as happened in the United States after the collapse of Enron and WorldCom. The Satyam episode may be identified as merely an abnormal or bizarre event, which is unpardonable and should not have occurred.

Such an assessment would, implicitly, amount to identifying the corporate governance system that we have in place after liberalisation as being adequate to prevent a large-scale corporate fraud with adverse implications for employees, shareholders, creditors and the economy. In this view, under normal circumstances a Satyam-type fraud should not arise. It arose only because this was a peculiar and unique case of coincidence of multiple failures of judgment on the part of monitors and regulators located at the various layers of overall governance structure.

It should be obvious that in a private enterprise system filled with joint stock companies, there could emerge a difference in the interests of the managers or managing promoters, on the one hand, and the shareholders and other stakeholders, on the other. In the event, there is the danger that managers and/or promoters may function in ways that financially benefit them at the expense of the returns earned by the shareholders or the security of other stakeholders.

Governance structures are meant to prevent this. One way in which this is done is through the capital market which is seen as a monitoring and disciplining mechanism because it serves as a market for corporate control. Bad managements trigger stock price declines leading to their replacement due to pressure from existing shareholders or from new shareholders who exploit the lower share values to acquire an influential stake in the company. In practice, this kind of monitoring rarely works either because incumbent managements reveal partial or incomplete information or because minority shareholders would find it difficult and costly to fully monitor and discipline managers who put the company’s revenues and profits at risk.

Moreover, shareholders are beguiled by high stock prices, since they buy into the idea that high and rising stock prices are a sign of both good performance and good management. If accounts are manipulated and revenues and profits inflated, the stock market performance of the company improves and that improvement serves to conceal the fraud that is under way.

However, capitalism, it is argued, has designed a governance structure that is explicitly aimed at ensuring compliance and disclosure. That structure is multilayered, consisting of boards of directors which include independent directors expected to represent the interests of the minority shareholders and society at large, auditors who are expected to ensure that the books which provide information on the performance of the managers and the financial health of the company are in order, regulators who ensure that guidelines with regard to accounting standards, disclosure and good management practices are followed and agencies that can investigate and prosecute in case fraud of any kind is suspected. This combined with international accounting standards and disclosure norms that are ostensibly followed by IT companies (since they serve international clients and are listed in international markets) was seen as insuring against fraud.

It must be noted, however, that one consequence of liberalisation, which affects the system of corporate governance as well, is that it moves the system in the direction of “self-regulation,” since it sees bureaucratic intervention as being inimical to innovation and “efficiency.” Boards, auditors, shareholders and norms and guidelines should serve to ensure that managements adopt good practices, and regulators should come in principally when fraud is detected, to investigate and penalise so as to set an example. Experience even in developed countries has shown that this need not work. It is even less likely to do so in countries where the regulators are understaffed and their staff inadequately trained and underpaid.

Accounting fraud

We must recall that the late 1990s boom in U.S. stock markets was sustained through accounting fraud that afflicted even leading companies and the subsequent crash was spurred by revelations of such fraud. Charges of accounting fraud have been levelled against Enron, Adelphia Communications, Tyco, Peregrine Systems, Global Crossing, Worldcom and Parmalat, among others. It is in this light that the Satyam case must be examined. What has shocked observers is that the decision of the promoters of Satyam Computer Services to inflate revenues and profits, defrauding its investors in the process, was neither sensed nor detected at all levels of governance. There are a number of factors that seem to underlie this overall failure.

To start with, there was total failure at the level of the board and the auditors. This huge fraud which occurred over many years and left a hole of more than Rs.7,000 crore was completely missed by a high-profile board, which even agreed to allow the promoters to use its non-existent reserves to buy up two unrelated companies in which the promoters have a major stake. The board included independent directors who are respectable professionals and academics. In addition, the firm’s auditors, Price Waterhouse, one of the big four, failed to detect manipulation of this magnitude, despite the fact that it included claims of huge cash reserves that did not exist. As many have rightly argued, even a minimum of diligence would have proved this claim regarding reserves to be false leading to a detection of the scam.

The question that arises is whether self-regulation failed because these individuals and entities were paid by the company to undertake their role. A similar issue came up after the sub-prime mortgage crisis when observers asked whether the rating agencies, which were to serve as monitors of risk, discounted risk and gave high ratings because they were paid by the firms whose securities they rated.

According to reports, independent directors in Satyam Computer Services were being paid huge fees for their professional services, varying from Rs.12.4 lakh to Rs.99.48 lakh in 2006-07, in the form of commission, sitting fees and professional fees (“Satyam directors’ remuneration,” Business Line, December 30, 2008). This gives rise to the criticism that the practice of managements paying independent directors (and paying them well) could lead them to take a soft view of matters and not take their monitoring and correcting role seriously. Further, lack of adequate caps on revenues obtained by auditors from their clients also creates a problem. The search for large fee incomes and competition among auditors to increase market share do encourage auditors to take the claims of their large clients and the documents they produce at face value, dropping the minimal checks which would possibly have revealed the Satyam fraud. Here again, the fact that the monitor is paid by the monitored seems to be a major source of the problem.

A second area of failure was the inability of agencies specially created to monitor companies that are listed on stock exchanges such as the Securities and Exchange Board of India. This too is the result of a transition to a form of regulation that has regulatory forbearance as its fundamental motif. This forbearance was all the greater in an industry like information technology which was privileged because of its success.

Industry and government

Finally, system failure seems to be also the result of the close relationship of the industry with the State and Central governments. Much has been written about the close association of Ramalinga Raju with political leaders especially at the State (Andhra Pradesh) level, and allegations have been made of special favours to him from the government before the scam and a tendency to protect him after the shocking confession. Comparisons of the very different treatment meted out to Ramoji Rao and Ramalinga Raju, even though the former was only being investigated for charges of malpractice of which he was exonerated, are a recurrent theme in the media.

These multiple failures suggest that the Satyam episode is not just an isolated instance of malpractice which must be dealt with in isolation. It is also the product of an institutional and regulatory environment that provides the space for one Satyam and, therefore, possibly for more such Satyams. That environment too needs investigation and reform.

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